Thursday, October 4, 2012 - 14:28 - Rachel Wolcott
Credit derivatives dealers can expect to see specific rules and regulations to address some of the peculiarities of that market, said Edouard Vieillefond, director in charge of regulation policy and international affairs at French regulator Autorité des marchés financiers (AMF). Despite the huge amount of regulation already aimed at the broader derivatives market, there is concern that it will be insufficient to cover continuing questions that regulators have about its functioning.
"The question is will the reform currently under finalisation or implementation, such as EMIR in Europe, be enough? Credit default swaps are derivatives on credit that look like insurance products. They are so specific they may deserve specific treatment and additional regulatory requirements or perhaps a better harmonisation of the prudential and the traditional market conduct regulation," Vieillefond told Compliance Complete.
Vieillefond added that, globally, regulators are looking at a number of issues related to credit default swaps (CDS) and will discuss them at this week's International Organization of Securities Commissions (IOSCO) board meeting. He said that by year-end or by the first half of 2013, the CDS market can expect some further guidance or standards from IOSCO and perhaps other regulators.
"There are some issues with the price formation process that makes us think that this is a very specific instrument that needs its own rules," he said.
The AMF, IOSCO and the U.S. Securities and Exchange Commission (SEC) have all published concerns about credit derivatives over the past year. The AMF outlined its 'Further questions about the functioning of the CDS market' in its Risk and Trend Mapping report published in July.
IOSCO published its report, The Credit Default Swap Market, in June. The SEC put out its own research in March and highlighted the statistic that 87.2 percent of CDS transactions are concentrated in the top-15 dealers.
As the sovereign debt crisis in Europe worsens and regulators pick over the details of the JP Morgan CDS trading losses, it appears the regulators' further investigations of the CDS market will soon materialise into rules especially designed for these instruments.
CVA trades and the pro-cyclical effect
At the top of the regulators' list of worries is that CDS are increasingly being used for regulatory purposes in credit value adjustment (CVA) trades. Regulators and dealers alike have noticed a problematic effect of the Basel III CVA charge, by which counterparty risk is calculated on the basis of CDS spreads. Under Basel III, banks are allowed to buy CDSs to offset capital requirements. This increase in activity once the capital requirement is introduced in 2013 could, it is feared, distort the CDS market.
"It can create a world where there are lots of natural buyers of CDS. It may encourage banks to buy CDS protection to reduce capital requirements related to their counterparty credit risk [noting that CDS are used in the calculation of the CVA] and these may have an important impact on those markets. It may create some kind of feedback loop. The more CDS you buy to hedge your counterparty risk, the more the CDS increase in value and the more markets become difficult, volatile and possibly overvalued," Vieillefond said.
This feedback loop becomes more of a concern, he argued, because of the concentrated nature of the market (87.2 percent held by the top-15 dealers). "We already have doubts today because of the concentration of the sector and the number of major players. As the effect of CVA becomes bigger it will become more of an issue. I think it needs to be specifically addressed for CDS," Vieillefond said.
This CVA feedback loop or pro-cyclicality issue has proven a difficult one for regulators to address; however, there should be a timetable for its resolution set out in the coming days or weeks — following the IOSCO board meeting.
Another issue rattling regulators is the jump-to-default risk — the risk of immediate default — inherent in CDS. Jump-to-default risk, argues the AMF, "seriously complicates the management of risk in the CDS market, since the resulting price discontinuity is hard to model and the seller's collateral requirement may be underestimated, thus intensifying counterparty risk." This characteristic of CDS is something regulators are seeking to address.
"The jump-to-default characteristic of CDS — the price discontinuity before default — creates specific needs for risk management tools and for close supervision of the banks when they try to value CDS," Vieillefond said.
Vieillefond pointed out that CDS are increasingly having an impact on bankruptcy proceedings. In France there already have been a few cases where bankruptcy has been much more difficult for companies to negotiate with banks, because creditors have hedged their exposure using CDS. "It may also have an impact on the bankruptcy procedures: if all the creditors are hedged through CDS, what's the incentive to accept some bail-ins?" he said.
This aspect of CDS use is one that regulators may seek to add guidance or rules.
Sovereign debt and counterparty risk
Another peculiarity of the CDS market regulators are unhappy with is banks selling protection on their home sovereigns or other credits to which the bank is exposed to counterparty risk. This activity could be another aspect of the CDS market that attracts more rules.
"There are still banks that sell protection on the sovereign debt of their own country — the sovereign of that bank. If the sovereign fails, the banks will probably have failed," Vieillefond said.